Debt dynamics for dummies

Krugman again does a great job showing that the risks of explosive debt are way overblown.  As he says:

"So even with substantial deficits, the pace of long-term budget worsening is very slow."

It is not difficult to understand debt dynamics.  The ratio of debt to income (GDP) is a measure of the capacity to repay debt.  If the economy grows faster than debt, the debt-to-GDP ratio falls.  GDP grows with demand expansion, and debt grows at the pace of the interest on the debt.  In other words, if the economy grows faster than the rate of interest, then the debt-to-GDP ratio will fall even if the government runs deficits.

The graph below shows the growth rate and the real rate of interest on government bonds for the US since 1990.  As it can be seen, since 2003, with the exception of the Great Recession, the rate of interest has been below the rate of growth.

The debt-to-GDP ratio has only increased (see graph below), because the crisis has caused significant deficits to accumulate.  Note that in the 1990s, a combination of lower interest rates, higher growth and fiscal surpluses had stabilized debt, which starting growing in the Reagan years.

Finally, note the growing deficits in the figure below have reversed with a very mild recovery in 2010. Interest will remain low. What is needed is a stronger recovery to get growth going and that would increase revenue (allow for reduced spending on several things like unemployment insurance) and eventually lead to a lower debt-to-GDP ratio.

The way out of the fiscal problems is growing!  Even dummies should get this right.